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Parallels Between The 1997 Asian Financial Crisis And U.S. Growth Today

Richmond Fed President Lacker has reminded us of the U.S. recovery in 1997 and 2003 in the face of overwhelming Asian economic troubles. The lesson of the Asian Financial Crisis is briefly recapped with the actual impact on U.S. growth and inflation shown. After the U.S. recovered in 2010, it is European Sovereign Debt Crisis which darken the economic cloud but this shouldn’t derail us from the bigger economic picture. SPY with its collection of big chip companies like AAPL and XOM would be an excellent vehicle to ride the U.S. recovery. SPY has paused in its price range as European woes prevent its raise but this should not be the case for long. Potential catalyst for SPY is stated. I quote the following from Richmond Federal Reserve President Jeffrey M. Lacker during his speech earlier this month to the Virginia Bankers Association and Virginia Chamber of Commerce. The economic outlook can change rapidly, and judgments about appropriate policy need to respond accordingly. It’s not hard to find historical examples: The outlook for real activity shifted dramatically from late 1998, when overseas turmoil was thought to jeopardize U.S. growth, to early 1999, when it became clear that the effects would be minimal and activity was accelerating. Similarly, the outlook for growth and inflation shifted significantly from mid-2003, when inflation seemed to be sinking below 1 percent, to early 2004, when growth and inflation were clearly rising. Arguably, the Fed fell at least somewhat behind the curve in each case. President Lacker provided a very good example of the recency bias where people tend to focus on the recent events to the extent where they are too absorbed to look into the future. The 1997 Asian Financial Crisis and the 2003 SARS health crisis hit Asia which resulted in concerns over growth in the United States which were blown out of proportion. There are draw parallels with the economic situation today if we replace Asia with Europe as the economic source that is dragging down the U.S. It would be instructive to look at the actual economic growth and inflation in the U.S. during this period. This is the best example for the Fed’s insistence that low energy prices are transitory in nature and the need to see the bigger picture and to get ahead of the curve. 1997 Asian Financial Crisis The 1997 Asian Financial Crisis started in Thailand where speculators were successful in pushing down the value of the Thai baht to the point where it became virtually worthless. Other Asian countries follow suit to devalue their currencies to protect their vulnerable export sector with the notable exception of Malaysia which implemented currency control. Hot capital flows fled Asia and growth in the U.S. was negatively impacted as seen in the chart below before and after the crisis. (click to enlarge) If we were to look at these growth numbers with today’s eyes, it will look like a pretty solid growth trajectory to us. Then again, we have to remember that this is 2 decades ago where the U.S. is still the engine of growth globally and China was just emerging as the manufacturing hub with its low labor cost. The IMF intervention in July 1997 for Thailand marks the beginning of a serious crisis and we saw growth in the U.S. dropped from 6.2% in the second quarter of 1997 to 5.2% in the third quarter and 3.1% in the fourth quarter of 1997. As a sign of the emergencies of the times, Indonesia had to asked the IMF and World Bank for help in October 1997 after its rupiah dropped by 30% in 2 months (which puts the 1 day 40% CHF decline in perspective after the surprise SNB decision to abandon the EURCHF 1.2 floor on 15 January 2015.) and by January 1998 Indonesians were stockpiling necessities. In May 1998, President Suharto had to resign after 32 years in power due to widespread public discontent with riots on the streets. This was the beginning of serious concerns over a widespread financial crisis engulfing the U.S. and the world. However on hindsight, it was exaggerated as the real impact of the Asian Financial Crisis never really reached the shores of the U.S. in the manner which it affected South Korea, Thailand, Indonesia and Russia. (click to enlarge) Inflation dropped drastically between 1997 and 1998 as the crisis heats up from 3.25% to less than 1.5% within a year. The Fed responded by cutting interest rates by 0.25% on October and November 1998 and by then at the end of 1998, the crisis has largely passed. The Fed went on to reverse its rate cut decision in 1998 by increasing it by 0.25% each in August and November 1999 back to 5%. So the crisis of 1997 shows that the impact can come quickly and it passed quickly. By the time, the worst of the crisis was exaggerated and reported in the market, the crisis has passed and growth had returned. Current Situation The difference between 1997 and the 2007 Credit Crunch that led to the Great Recession of 2008 and 2009 is that they had their source in the housing bubble in the United States. This lead to a longer recovery period but we can see from the chart below that growth has returned in 2010 after the contraction of 2008 and 2009. (click to enlarge) Also the difference between then and now is that after the U.S. recovered in 2010, it is Europe’s turn to get into trouble with their sovereign debt crisis. In contrast, Asia was able to recover relatively quickly after the crisis with a V shape recovery from 1999. This is why the current U.S. recovery took a longer period of time and at such a low rate of economic recovery. However we must acknowledged that enough time has passed and there has been substantial improvement for the U.S. economy. (click to enlarge) We can see in the overlay of GDP growth (listed on the left hand side) and inflation (on the right side). GDP growth has hit 5% in the third quarter of 2014 and this is an 11 year high. On 30 January 2015, we will see the advance estimate for the fourth quarter of 2014 and it is expected to come in strongly at 3.0%. Overall growth for year 2014 should be between 2.5% and 3%. This is a strong economic growth and the U.S. is the only major developed economy to hit this growth rate. The only difference is that the inflation rate has divergence and gone down. There are some pundits that will see this as signs of future economic weakness due to weakening of global demand. This is unlikely to be case as we know that this is due to increase supply of oil from the U.S. due to advances in technology and the unwillingness of OPEC to reduce their output of oil. Benefiting From U.S. Growth The way which investors can benefit from a strong and sustained U.S. growth is to gain exposure to a diversified portfolio of U.S. stocks by the way of the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). SPY gathers the best companies in the U.S. which are likely to receive the bulk of the increased expenditure when the U.S. recovery gathers steam. Think of company like Apple (NASDAQ: AAPL ) which is the top company in this ETF with 3.54%. AAPL is the company you think of when you want to purchase a new phone or laptop. The next on the list is Exxon Mobil (NYSE: XOM ) with 2.14% of the ETF. XOM has both upstream and downstream activities and its greatest brand for the public is probably the petrol pump of Mobil. While XOM will be pressured during this period of the low energy prices, we can be sure that it is here for the long run and will benefit when smaller competitors are chased out of the market. I could go on but the point is that SPY contains the blue chip companies of the U.S. and you can’t go wrong with it. Its growth might be lesser than if you picked the next Google but you have lesser chance of losing money on a mistake and this is where you should park the bulk of your wealth. SPY is heavily tilted towards technology companies with 17.89% weighting, financial services at 15.25%, healthcare at 14.71%, industrials at 11.18% and consumer cyclical at 10.59% to round up the top 5. Its price is also reasonable at 17 times earnings. (click to enlarge) We can see that after dip of ‘the buy and go away’ month of October, we have seen strong growth in the SPY in November. From December onward to this month, SPY has been in a range of $197 to $210. This represents market worry about the European contagion. As we have seen in the Asian Financial Crisis which the Richmond Fed President has kindly reminded us, this is likely to be overblown in the media. The U.S. recovery has started since 2010 and it has already been 4 years. It has withstood criticism of the quality of the recovery and the tapering of the Fed’s QE which is thought to artificially inflate the equity market. After the Fed formally ended QE3 in October 2014, there was some pullback in the equity market (also due to investor psychology and also bearish articles such as this Forbes article urging readers to stay in Cash.) but it has largely corrected itself. There will always be negative news in the market and we should look beyond them to the bigger picture and trend that has built up over time. The U.S. recovery has been strong and today we had the benefit of looking it through a recent historical perspective. This should guide us in our investment decision framework going forward. A potential catalyst for the SPY would be a good Advance fourth quarter GDP reading exceeding expectations of 3.0% on 30 January 2015. If you are going to take a long position on SPY, it would be advisable to do so before that.

For Passive Funds, A Stronger Link Between Fees And Performance

By Michael Rawson When shopping for products of unknown quality, price forms a cue that shoppers can use to differentiate products. It is often a safe assumption that a higher priced product offers better performance than a lower priced product. For instance, the Porsche 911 lists for $93,000 while the Chevy Malibu will set you back $20,000. But this is not always the case, particularly with fund investing. Unlike the Porsche, there is no cachet from buying a high-priced fund. Still, price can be useful when predicting results – though not in the way fund companies would like. Morningstar’s Analyst Rating for funds is based on five pillars: People, Parent, Process, Performance, and Price. The first three of these pillars are somewhat qualitative, while Performance and Price are much more quantitative. Price is the most tangible, both in terms of the impact of price on fund performance and comparability across funds. On average, we find that the higher the price of a fund, the worse its performance tends to be, and the link between fees and performance is stronger for passive funds. The chart below illustrates the relationship between price and performance among U.S. equity funds. It shows the average alpha (excess returns after adjusting for risk relative to the category benchmark) for all funds grouped into five quintiles by expense ratio. The y-axis shows the average alpha and the position on the x-axis indicates the average expense ratio for the group. We included all U.S. equity funds that existed five years ago and survived through today. Because some funds have performance-based fees, we used the 2009 annual report expense ratio rather than the expense ratio during the sample period. This also simulates the results of picking funds based on currently available information and examining future performance. As the chart illustrates, there appears to be an inverse relationship between fees and performance. The lowest-fee quintile has an average expense ratio of 0.64% and an average alpha of negative 0.71%, while the highest-fee quintile has an average expense ratio of 2.02% and an average excess return of negative 1.94%. However, grouping the funds into quintiles masks the tremendous variability in the relationship between fees and performance, which is better illustrated in the following graph. Here, the relationship appears much less precise. In fact, a regression of alpha on expense ratio has an R-squared of just 6%, suggesting that fees explain a small portion of the overall variability in fund performance. However, there are a few issues that may obfuscate this relationship. The chart above includes all U.S. equity funds, even though small-cap funds have higher expense ratios than large-cap funds. It also includes all available share classes despite the fact that low-cost institutional share classes must outperform high-cost retail share classes of the same fund. Also, the relationship between fees and performance might be different for active and passive funds. Because passive funds seek to match an index less fees, the relationship between fees and performance might be stronger among them. In contrast to passive funds, well-run active funds have a better chance of earning back their fees. In order to address these issues, we narrowed our focus to large-cap U.S. equity funds and removed multiple share classes of the same fund to get a cleaner read on the link between fees and strategy performance. We also grouped active and traditional broad passive funds separately and removed most niche index and strategic beta funds (index funds that make active bets in an attempt to outperform traditional indexes). The results are shown in the following chart. In this chart, the relationship between fees and performance is a bit clearer. For active funds, there is still a tremendous amount of variability, but there appear to be more dots in negative territory as we move from lower- to higher-cost funds (from left to right on the chart). Passive funds seem to hew closer to a straight line. Quantifying this relationship with a regression that expresses the expected alpha as a function of the expense ratio highlights the negative slope. For active large-cap funds, the expected alpha is approximately negative 1.21 times the expense ratio. In other words, a fund with an expense ratio 10 basis points above the average would be expected to deliver an alpha 12 basis points lower than average. While the relationship is significant, the R-squared is only 6%. Despite the poor fit of the model linking fees to performance for active large-cap funds, lower-fee funds still had a better chance of outperforming on average. This simply indicates that, while fees are predictive of performance, there are many other factors that matter. For passive large-cap funds, the R-squared is 38%. This means that there is a cleaner relationship between fees and performance for passive funds than active funds. In the sample studied, active funds in the lowest expense ratio quintile had a 28% chance of earning a positive alpha compared with just a 15% chance for those in the highest-cost quintile. But the relationship is even stronger for passive funds. About 52% of passive large-cap funds in the lowest-cost quintile earned a positive alpha (however small), while none of the funds in the highest-cost quintile did. This suggests that investors can increase their probability of success by selecting low-cost funds. Fortunately, there are a lot of low-cost passive and active funds to choose from. Vanguard Total Stock Market ETF (NYSEARCA: VTI ) holds more than 3,000 U.S. stocks and offers similar exposure to iShares Russell 3000 (NYSEARCA: IWV ) . The funds have had similar returns and risks over the past decade. However, the Vanguard fund charges 0.05% compared with 0.20% for the iShares fund. Assuming both funds return 5% annually gross of fees over 10 years, a $100,000 investment in VTI would be worth about $2,300 more at the end of the period than an investment in IWV. Among active funds, Price is one of five pillars taken into consideration in the Morningstar Analyst Rating for funds. When there are multiple funds that offer similar exposure, the lowest-cost option may be the prudent choice. Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Consider This Before You Sell On Fears Of A Strong Dollar

Markets tumbled Tuesday on a number of weak earnings reports. The strong U.S. dollar was a major culprit. Historically, currency changes are not a good predictor of subsequent stock market returns. Investors may wish to consider rebalancing their portfolios, but there is little evidence to suggest a major change in strategy is warranted. Markets had a turbulent Tuesday with earnings reports from firms like Microsoft (NASDAQ: MSFT ), Caterpillar (NYSE: CAT ) and Procter & Gamble (NYSE: PG ) stoking fears that economic growth is slowing. However, a more critical look into these reports suggests that strength in the U.S. dollar is a major culprit. For example, Procter & Gamble reported core earnings of $1.06 versus $1.15 in the previous year, a reduction of nearly 8%. But looking closer net sales were down 4% nearly mirroring a five percentage point impact from foreign exchange. In fact, adjusting for the effects of foreign exchange, volumes were flat (Table 1). While flat growth may be little reason to cheer, it also seems to be scant reason to overreact. As an investor before you react to currency headwinds it is logical to evaluate the effect of a stronger dollar in its historical context. Table 1: P&G’s Net Sales Drivers Oct. – Dec. 2014 Net Sales Drivers Volume Foreign Exchange Price Mix Other* Net Sales Organic Volume Organic Sales Beauty, Hair & Personal Care -2% -4% 1% 0% -1% -6% -2% -1% Grooming -2% -7% 4% 0% 0% -5% -2% 2% Health Care -2% -4% 0% 3% 0% -3% -2% 1% Fabric Care and Home Care 2% -6% 1% 0% -1% -4% 2% 4% Baby, Feminine and Family Care 0% -6% 1% 3% 0% -2% 0% 4% Total P&G 0% -5% 1% 1% -1% -4% 0% 2% *Other includes the sales mix impact of acquisitions/divestitures and rounding impacts necessary to reconcile volume to net sales. Source: Procter and Gamble Earnings Press Release. The stock market is volatile, but so are currencies. Over the past thirty years the dollar has waxed and waned against a basket of foreign currencies (Figure 1). Sometimes the U.S. dollar and the market move upward in lock step, while other times they diverge. Figure 1: The U.S. Dollar vs. The S&P 500 (click to enlarge) Do you see a correlation between the two? I do not and incidentally neither does Excel. The correlation between the dollar index and the S&P 500 (NYSEARCA: SPY ) is -0.211, most likely any correlation is simply an artifact of the dollar being in general more weak over the past ten years while the market has moved up over time. How about if we think about the situation in a different way? What if a rising dollar is associated with subsequent poor performance in the stock market? In other words, since P&G’s last earnings report stemmed from changes in the exchange rate over the past six months what if there was a correlation between the six month appreciation or depreciation of the dollar and subsequent returns in the stock market? These numbers are very easily manipulated in Excel and the correlation between six month past currency moves and three month forward stock market returns is -0.043. There is almost no correlation between the two. To further emphasize the point I created a scatterplot of the two data sets (Figure 2). The R squared of least squares regression is 0.00186, indicating no correlation. Figure 2: Three Month Subsequent S&P 500 Return Vs. Six Month Prior Appreciation in the U.S. Dollar (click to enlarge) Intuitively, this finding makes a great deal of economic sense. Currency moves are a zero sum game. If the dollar goes down against the Euro then U.S. exports are cheaper for Europeans and the reverse is true for imports. While U.S. companies on the whole may suffer because they sell abroad an appreciating dollar also makes assets denominated in dollars more attractive to foreign investors. In aggregate there is little reason to bet on the dollar causing the U.S. market to move up or down. Some market pundits are calling for a correction or worse in the stock market, however, there is no historical evidence to suggest that strength in the U.S. dollar should be correlated with stock market corrections. The S&P 500 closed at 2029 today, about 3% off its all-time intraday high of 2093. While market prognosticators constantly pitch timing the market, moves of less than 10% are impossible to time accurately. By the time the market opened today we were already down 3% from all-time highs. What if the market goes down a total of 10%? First consider that it is only after a move higher that you would know to reenter the market. Then consider that it is equally likely the market’s next move will be up. In a nutshell this explains why timing short-term corrections is a waste of time and money, although investors never seem to learn that this is the case. At the moment currency changes are still rippling through the market. One way to rebalance your portfolio would be to favor domestic stocks that capitalize on cheaper imports and sell their products within the United States. Foreign stocks that are exporters should benefit from the opposite trend and allow for a portfolio that is still balanced between foreign and U.S. based corporations. For example, some U.S. based companies that should see stronger earnings as the result of dollar appreciation are: AutoNation (NYSE: AN ), Costco (NASDAQ: COST ) and Michael Kors Holdings (NYSE: KORS ). These three companies need to import goods from abroad and sell them in the United States (with each having a minimum of 70% of revenues domestically). Foreign stocks that could benefit from a weaker euro include: Siemens ( OTCPK:SIEGY ) and Unilever (NYSE: UN ). Obviously this list is not all-inclusive and depending on whether you expect a weakening or strengthening economy you could favor more or less cyclical companies. Nearly every day market prognosticators try to convince investors to change their investment strategy. While it is difficult to ignore them when the market swoons that is precisely what most successful investors learn to do. It is more gratifying and ultimately more profitable to view short-term market fluctuations as random noise unless you have a compelling reason to think otherwise. Editor’s Note: This article discusses one or more securities that do not trade on a major exchange. Please be aware of the risks associated with these stocks.